by Thomas E. Woods, Jr.
TomWoods.com

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One of Ron
PaulÂ’s great accomplishments is that the Federal Reserve faces
more opposition today than ever before. Readers of this site will
be familiar with the arguments: the Fed enjoys special government
privileges; its interference with market interest rates gives rise
to the boom-bust business cycle; it has undermined the value of
the dollar; it creates moral hazard, since market participants know
the money producer can bail them out; and it is unnecessary to and
at odds with a free-market economy.

Unfortunately,
not all Fed critics, even among Ron Paul supporters, approach the
problem in this way. A subset of the end-the-Fed crowd opposes the
Fed for peripheral or entirely wrongheaded reasons. For this group,
the Fed is not inflating enough. (I have been told by one critic
that our problem cannot be that too much money is being created,
since he doesnÂ’t know anyone who has too many Federal Reserve
Notes.) Their other main complaints are (1) that the Fed is “privately
owned” (the Fed’s problem evidently being that it isn’t
socialistic enough), (2) that fiat money is just fine as long as
it is issued by the peopleÂ’s trusty representatives instead
of by the Fed, and (3) that under the present system we are burdened
with what they call “debt-based money”; their key monetary
reform, in turn, involves moving to “debt-free money.”
These critics have been called Greenbackers, a reference to fiat
money used during the Civil War. (A fourth claim is that the Austrian
School of economics, which Ron Paul promotes, is composed of
shills for the banking system and the status quo; I have exploded
this claim already – here,
here,
and here.)

With so much
to cover I donÂ’t intend to get into (1) right now, but it should
suffice to note that being created by an act of Congress, having
your boardÂ’s personnel appointed by the U.S. president, and
enjoying government-granted monopoly privileges without which you
would be of no significance, are not the typical features of a “private”
institution. IÂ’ll address (2) and (3) throughout what follows.

The point of
this discussion is to refute the principal falsehoods that circulate
among Greenbackers: (a) that a gold standard (either 100 percent
reserve or fractional reserve) or the Federal ReserveÂ’s fiat
money system yields an outcome in which outstanding loans cannot
all be paid because there is “not enough money” to pay
both the principal and the interest; (b) that if the banks are allowed
to issue loans at interest they will eventually wind up with all
the money; and that the only alternative is “debt-free”
fiat paper money issued by government.

My answers
will be as follows: (1) the claim that there is “not enough
money” to pay both principal and interest is false, regardless
of which of these monetary systems we are considering; and (2) even
if “debt-free” money were the solution, the best producer
of such money is the free market, not Nancy Pelosi or John McCain.

To understand
what the Greenbackers have in mind with their proposed “debt-free
money,” and what they mean by the phrase “money as debt”
they use so often, letÂ’s look at the money creation process
in the kind of fractional-reserve fiat money system we have. Suppose
the Fed engages in one of its “open-market operations”
and purchases government securities from one of its primary dealers.
The Fed pays for this purchase by writing a check on itself, out
of thin air, and handing it to the primary dealer. That primary
dealer, in turn, deposits the check into its bank account –
at Bank A, let us say.

Bank A doesnÂ’t
just sit on this money. The current system practically compels it
to use that money as the basis for credit expansion. So if $10,000
was deposited in the bank, some $9,000 or so will be lent out –
to Borrower C. So Borrower C now has $9,000 in purchasing power
conjured out of thin air, while Person B can still write checks
on his $10,000.

This is why
the Greenbackers speak of “money as debt.” The $9,000
that Bank A created in our example entered the economy in the form
of a loan to Person B. In our system the banks are not allowed to
print cash, but they can do what from their point of view is the
next best thing: create checking deposits out of thin air. Banks
issue loans out of thin air by opening up a checking account for
the customer, whose balance is created out of nothing, in the amount
of the loan.

The Greenbacker
complaint is this: when the fractional-reserve bank creates that
$9,000 loan at (for example) ten percent interest, it expects $900
in interest payments at the end of the loan period. But if the bank
created only the $9,000 for the loan itself and not the $900 that
will eventually be owed in interest, where is that extra $900 supposed
to come from?

At first this
may seem like no problem. The borrower just needs to come up with
an extra $900 by working more or consuming less. But this is no
answer at all, according to the Greenbacker. Since all money enters
the system in the form of loans to someone – recall how our
fractional-reserve bank increased the money supply, by making a
loan out of thin air – this solution merely postpones the problem.
The whole system consists of loans for which only the principal
was created. And since the banks create only the principal amounts
of these loans and not the extra money needed to pay the interest,
there just isnÂ’t enough money for everyone to pay off their
debts all at once.

And so the
problem with the current system, according to them, is that our
money is “debt based,” entering the economy as a debt
owed to a bank. They prefer a system in which money is created “debt
free” – i.e., printed by the government and spent directly
into the economy, rather than lent into existence via loans by the
banks.

In the comments
section at my blog I have been told by a critic that even under
a 100% gold standard, with no fractional-reserve banking, the charging
of interest still involves asking borrowers to do what is literally
impossible for them all to do at once, or at the very least will
invariably lead to a situation in which the banks wind up with all
the money.

All these claims
are categorically false.

It is not true
that “there is not enough money to pay the interest” under
a gold standard or a purely free-market money, and it is not even
true under the kind of fractional-reserve fiat paper system we have
now. It certainly isn’t true that “the banks will wind
up with all the money.” There are plenty of reasons to condemn
the present banking system, but this isnÂ’t one of them. The
Greenbackers are focused on an irrelevancy, rather like criticizing
Barack Obama for his taste in menÂ’s suits.

I want to respond
to this claim under both scenarios: (1) a 100% gold standard with
no fractional reserves; and (2) our present fractional-reserve,
fiat-money system.

In order to
do so, letÂ’s recall what money is and where it comes from.

Money emerges
from the primitive system of barter, in which people exchange goods
directly for one another: cheese for paper, shoes for apples. This
is an obviously clumsy system, because (among a great many other
reasons I trust readers can conjure for themselves) paper suppliers
are not necessarily in the market for cheese, and vice versa.

A money economy,
on the other hand, is one in which goods are exchanged indirectly
for each other: instead of having to be a hat-wanting basketball
owner in the possibly vain search for a basketball-wanting hat owner,
the basketball owner instead exchanges his basketball for whatever
is functioning as money – gold and silver, for example –
and then exchanges the money for the hat he wants.

People dissatisfied
with the awkward and ineffective system of barter perceive that
if they can acquire a more widely desired and more marketable good
than the one they currently possess, they are more likely to find
someone willing to exchange with them. That more marketable good
will tend to have certain characteristics: durability, divisibility,
and relatively high value per unit weight. And the more that good
begins to be used as a common medium of exchange, the more people
who have no particular desire for it in and of itself will be eager
to acquire it anyway, because they know other people will accept
it in exchange for goods. In that way, gold and silver (or whatever
the money happens to be) evolve into full-fledged media of exchange,
and eventually into money (which is defined as the most widely accepted
medium of exchange).

Money, therefore,
emerges spontaneously as a useful commodity on the market. The fact
that people desire it for the services it directly provides contributes
to its marketability, which leads people to use it in exchange,
which in turn makes it still more marketable, because now it can
be used both for direct use as well as indirectly as a medium of
exchange.

Note that there
is nothing in this process that requires government, its police,
or any form of monopoly privilege. The GreenbackersÂ’ preferred
system, in which money is created by a monopoly government, is completely
foreign and extraneous to the natural evolution of money as we have
here described it.

And make no
mistake: money has to emerge the way we have described it. It cannot
emerge for the first time as government-issued fiat paper. Whenever
we think weÂ’ve encountered an example in history of a pure
fiat money being imposed by the state, a closer look always turns
up some connection between that money and a pre-existing money,
which is either itself a commodity or in turn traceable to one.

For one thing,
pieces of paper with politiciansÂ’ faces on them are not saleable
goods. They have no use value, and therefore could not have emerged
from barter as the most marketable goods in society.

Second, even
if government did try to impose a paper money issued from nothing
on the people, it could not be used as a medium of exchange or a
tool of economic calculation because no one could know what it was
worth. Are three Toms worth one apple or seven fur coats? How could
anyone know?

On the other
hand, the money chosen by the market can be used as a medium of
exchange and a tool of economic calculation. During the process
in which it went from being just another commodity into being the
money commodity, it was being offered in barter exchange for all
or most other goods. As a result, an array of barter prices in terms
of that good came into existence. (For simplicityÂ’s sake, in
this essay weÂ’ll imagine gold as the commodity that the market
chooses as money.) People can recall the gold-price of clocks, the
gold-price of butter, etc., from the period of barter. The money
commodity isnÂ’t some arbitrary object to which government coerces
the public into assigning value. Ordering people to believe that
worthless pieces of paper are valuable is a difficult enough job,
but then expecting them to use this mysterious, previously unknown
item to facilitate exchanges without any pre-existing prices as
a basis for economic calculation is absurd.

Of course,
fiat moneys exist all over the world today, so it seems at first
glance as if what I have just argued must be false. Evidently governments
have been able to introduce paper money out of nothing.

This is where
Murray RothbardÂ’s work comes in especially handy. In his classic
little book What
Has Government Done to Our Money? he builds upon the analysis
of Ludwig von Mises and concisely describes the steps by which a
commodity chosen by the people through their voluntary market exchanges
is transformed into an altogether different monetary system, based
on fiat paper.

The steps are
roughly as follows. First, society adopts a commodity money, as
described above. (As I noted above, for ease of exposition weÂ’ll
choose gold, but it could be whatever commodity the market selects.)
Government then monopolizes the production and certification of
the gold. Paper notes issued by banks or by governments that can
be redeemed in a given weight of gold begin to circulate as a convenient
substitute for carrying gold coins. These money certificates are
given different names in different countries: dollars, pounds, francs,
marks, etc. These national names condition the public to think of
the dollar (or the pound or whatever) rather than the gold itself
as the money. Thus it is less disorienting when the final step is
taken and the government confiscates the gold to which the paper
certificates entitle their holders, leaving the people with an unbacked
paper money.

This is how
unbacked paper money comes into existence. It begins as a convertible
substitute for a commodity like gold, and then the government takes
the gold away. It continues to circulate even without the gold backing
because people can recall the exchange ratios that existed between
the paper money and other goods in the past, so the paper money
is not being imposed on them out of nowhere.

Free-market
money, therefore, is commodity money. And commodity money is not
“debt-based” money. When a gold miner produces gold and
takes that gold to the mint to be transformed into coins, he simply
spends the money into the economy. So free-market money does not
enter the economy as a loan. It is an example of the “debt-free
money” the Greenbackers are supposed to favor. I strongly suspect
that many of them have never thought the problem through to quite
this extent. If what they favor is “debt-free money,”
why do they automatically assume it must be produced by the state?
For consistencyÂ’s sake, they should support all forms of debt-free
money, including money that takes the form of a good voluntarily
produced on the market and without any form of monopoly privilege.

The free-marketÂ’s
form of “debt-free money” also doesn’t require a
government monopoly, or rely on the preposterously naive hope that
the government production of “interest-free money” will
be carried out without corruption or in a non-arbitrary way. (Any
“monetary policy” that interferes with or second-guesses
the stock of money that the voluntary array of exchanges known as
the free market would produce is arbitrary.)

But now what
of the Greenbacker claim that interest payments, of their very nature,
cannot be paid by all members of society simultaneously?

This is clearly
not true of a society in which money production is left to the market.
The Greenbacker complaint about interest payments in a fractional-reserve
system is that the banks create a loanÂ’s principal out of thin
air, and that because they donÂ’t also create the amount of
money necessary to pay the interest charges as well, the collective
sum of loan payments (principal and interest) cannot be made. Some
people, the Greenbackers concede, can pay back their loans with
interest, but not everyone.

But this is
not what happens in the situation we have been describing, in which
the money is chosen spontaneously and voluntarily by the individuals
in society, and in which government plays no role. Money in this
truly laissez-faire system is spent into the economy once it is
produced, not lent into existence out of thin air, so there is no
problem of “debt-based money” yielding a situation in
which “there is not enough money to pay the interest.”
There is no “debt” created at any point in the process
of money production on the free market in the first place. The free
market gives us “debt-free money,” but the Greenbackers
do not want it.

Read
the rest of the article

March
23, 2013

Thomas
E. Woods, Jr. [send him
mail; visit his
website], a senior fellow of the Ludwig von Mises Institute,
is the creator of Tom
Woods’s Liberty Classroom, a libertarian educational
resource. He is the author of eleven books, including the New
York Times bestsellers Meltdown
(on the financial crisis; read Ron Paul’s foreword)
and The
Politically Incorrect Guide to American History, and most
recently Nullification
and Rollback.

Copyright
© 2013 Thomas
Woods

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